What is CFD Trading?
CFDs are financial instruments that are derivatives. The underlying financial instruments are used to price these ‘Contracts for Difference.’ Stocks, commodities, indices, currency, and cryptocurrencies are all examples of CFDs. Almost any financial instrument that may be traded on the market is available in this format.
CFD trading allows you to bet on asset price movements in the future. One of two outcomes is possible: the asset’s price will rise over time, or it will fall over time. You agree to exchange the difference in the price of the underlying asset at the time the contract is begun against the time it is closed when you trade CFDs. CFDs can be traded to the upside or the downside – the choice is yours. This is in stark contrast to traditional trading or investing, in which asset price appreciation is required for profitable deals.
CFDs do not require real possession of the assets in question; instead, you trade a contract that reflects the price changes.
It all starts with a thorough examination of the financial instruments in question.
Interest rates, inflation rates, unemployment rates, and general economic performance all have a role in decision-making processes.
The financials of the company are equally significant in evaluating CFD performance.
You might be interested in trading oil CFDs, Apple CFDs, USD/EUR CFDs, S&P 500 CFDs, or any other commodity, stock, currency, index, and so on.
Although the availability of CFD trading choices varies by platform, the principles of trading CFDs remain the same.
1. Select a Trustworthy Trading Platform
Check for license and regulation, credibility, financial instrument availability, real-time pricing updates, speedy trade executions, a full suite of trading tools and resources, technical and fundamental analysis, leverage and margin, attentive customer service, and unbreakable security standards.
These are the most critical characteristics of a trustworthy trading platform. Consider them a gold standard when looking for a tried and true trading platform.
Superlatives and Too Good to Be True offers from any trading platform you register with should be avoided. Guaranteed returns are demonstrably false. CFD trading is a high-risk endeavor in which the vast majority of traders lose money. What many of these platforms don’t tell you is that about 70% – 80% of all traders end up losing money using CFDs. It’s a volatile market with constant whipsaw price movements.
When leverage is factored in, it is possible to lose more than your initial investment in any given trade. Read the fine print at all times. Trust impartial reviews of trading platforms on external review sites above ‘in-house’ or ‘on-site’ gushing endorsements. This is your money; use it wisely.
2. Take Caution When Using Leverage
If you’re new to the trading industry, leverage should be explained and understood.
Have you ever used a car jack to lift your vehicle while changing a tire? That right there is leverage. You are combining your strength, sometimes known as capital, with more power (the hydraulic lift) to obtain a much larger outcome.
CFD trading works in the same way. You are using your capital and the broker’s buying power to open much larger positions than your capital would allow. A leverage ratio of 10 to 1 means that for every €1 of your capital, you will have €10 in purchasing power. If the leverage ratio is 50 to 1, it means that every €1 of your capital has €50 in purchasing power.
What is the risk of leveraged trading?
Remember how I said at the beginning of this piece that there are two possible outcomes for a trade: profit or loss?
When your trades are profitable (ITM), leverage is your friend because it multiplies your gains. However, when your trades end out of the money (OTM), leverage becomes an issue. You will be liable for the entire amount of the trade if it goes against you, not just the capital you deposited in it.
3. Trade Sizing
Everyone’s budget is unique. You may be a low-risk trader, a swing trader, a day trader, or just a high-frequency trader.
Whatever your trading style, tastes, or budget, it is critical that you size your trades correctly. Metrics are used to decide how much of your available capital should be utilised on each trade. How much should you allocate to each CFD transaction if you have a budget of €5,000? The verdict is still out on this one, but I prefer to keep the numbers modest. If you consider that any particular trade should not exceed 1% – 2% of your available capital, you will only risk €50 – €100 on any given trade.
Keep in mind that if a trade goes against you, leverage of 10 to 1 or 50 to 1 will quadruple your liability.
Consider the following real-world example in USD:
You wish to acquire 1000 shares of XYZ stock at $10 per share in CFDs.
Your exposure is 1000 times $10, which equals $10,000.
If the margin requirement (the reciprocal of the leverage) is 10%, you must put up 10% of $10,000 = $1000 up front.
If you have $5,000 in your account, this trade represents a 2X portfolio leverage. As the required margin decreases from 10% to 9%, 8%, 7%, 6%, 5%…
As a result, the amount of cash you need to put up drops while your portfolio leverage on each of those trades increases. To reduce your possible losses and responsibility, carefully consider the leverage and trade size.
4. Understand Bullish and Bearish Prospects
There are bulls and bears in all forms of trade.
The bulls have optimistic pricing expectations. They anticipate that the price of the financial instrument will climb over time.
A bullish position in CFDs suggests that the future price is higher than the price at which the contract is opened. Your profit is the difference between them. With negative prospects, the future price must be lower than the price at which the contract was initiated. You repurchase the contract for a lower price, pocketing the difference.
This is the fundamental concept upon which a CFD operates. Bullish trading is referred to as going long, while bearish trading is referred to as going short.If you are trading oil CFDs and believe that global supply problems would cause crude oil prices to rise, you would go long on crude oil. If you believe that surplus production will flood the markets with additional crude oil, you may want to sell oil CFDs.
5. CFD Hedging Principles
Another key trading concept is hedging. Consider a hedge in your garden as an example. It acts as a barrier between your home and the outside world. In some ways, CFD hedging is also a sort of protection. You must have another trade or investment open on a trading platform for a hedge to perform successfully as a CFD.
For example, suppose you hold Google stock and want to safeguard it from downward pricing pressures.
Falling prices result in losses with a normal investment. However, you can protect your portfolio by hedging your Google stock and trading CFDs to the downside, sometimes known as selling short.
Overall, hedging may not result in a win, but it can surely decrease losses on a correctly hedged bet.
The goal is to always minimize losses. There are other different risk-mitigation tools available, including:
- Stop-Loss Orders
- Take Profit Orders
- Methodical Planning
- Portfolio Diversification